On a brisk January morning, Fabrice Gould walked into the San Diego Convention Center and took his badge and packet for the Crowdfund Global Expo with little sense of what crowdfunding might do for his company. Of course, there was Kickstarter--who doesn't know about Kickstarter? And he also knew that the business he's starting, a service called Diggen to allow Web retailers to better target shoppers, was hardly about to inflame the passions of the kinds of people who donate money on sites like Kickstarter. Gould has no snazzy smartwatch to offer his backers, that much is certain.

But he could offer them equity, or maybe debt, in his company. Diggen aims to give consumers the power to manage the personal information they present to websites. "You're in control, you get transparency, and it gives you a better experience, really, over anything digital," Gould told me as the first day of the conference drew to a close. Soon, he plans to present a nearly finished product to prospective clients--and investors. Ultimately, over the next year, he would like to raise a seed round of about $500,000 in financing.

The Expo held the promise that this money could come through crowdfunding securities. The idea that small companies should be able to sell small amounts of stocks and bonds to investors--which they've been prohibited from doing since the Depression--has exploded over the past few years. Sherwood Neiss and Jason Best, two of its first advocates, suggested that crowdfunding could deliver $300 billion to the treasuries of the nation's small businesses from the savings accounts of ordinary Americans.

"A lot has changed in 80 years, and it's time our laws did as well," declared President Obama in April 2012, as he prepared to change those laws and put his signature to the JOBS Act. Standing in front of Neiss, Best, and a handful of other entrepreneurs who helped nudge the legislation through Congress, the President called crowdfunding "a potential game changer. Startups and small businesses will now have access to a big, new pool of potential investors. Namely, the American people."

Under Title III of the JOBS Act, a company can raise $1 million a year from the crowd without having to go through the very expensive process of registering those securities with the Securities and Exchange Commission. A company can't sell that stock (or debt) on its own; instead, it will have to go through a website hosted by an intermediary. And some disclosure will still be required, including audited financial statements for campaigns of over half-a-million dollars, although the industry's boosters have been working hard to change that.

How crowdfunding will work in practice, though, is still a bit hazy. Gould was grappling hopefully with the details during the Expo. "I don't think it's at all ideal," he said as we sat outside an exhibitor's room that had been transformed into an open bar. "But it's a lot more likely than I thought." Or is it? With final rules about to land any day now, crowdfunding may prove far more costly, bureaucratic, and exclusionary than its advocates originally envisioned. It's enough to make one wonder if, despite all the excitement, crowdfunding will really make sense for any business, let alone Gould's.

First Hurdle: Find The Right Portal

Perhaps no group of entrepreneurs is as eager to see Title III take effect as those who plan to use it to help other businesses raise money. The law, after all, requires companies that sell stock to the crowd to go through an intermediary, which will usually be an Internet "portal." In December 2012, securities regulators scoured the Internet and found nearly 8,800 domains with crowdfunding in their name. About 6,800 of these had materialized after the JOBS Act was signed into law.

The new entrepreneurs of disruptive finance had diverse backgrounds, but D.J. Paul, a former bond salesman and film producer who became one of the industry's early organizers, says the serious players break roughly into two camps: technologists and financiers. Ryan Feit was typical of the financiers.

"For all the talk about its disrupting traditional finance, crowdfunding is hardly shaping up to be a cheaper source of capital."

He was young, just 29 when the JOBS Act passed, but he had already logged time at both a private equity firm and a hedge fund and had returned to school for a business degree. "I wanted to do something more entrepreneurial than just investing but didn't have an idea for a company," he says. Then, in the fall of 2011, he heard about the work Best and Neiss were doing to pass a crowdfunding bill and signed on to help. By the time he graduated from Wharton the next May, he had incorporated his crowdfunding portal, SeedInvest. He launched his website that summer, though it didn't do much, because there was nothing to do until the rules were in place.

Intermediaries must be either a traditional broker-dealer or a portal like SeedInvest, a new kind of entity created by the law. Portals are supposed to be a less-regulated, and therefore less-expensive, type of broker. In exchange for that leeway, they face some limitations. They can't provide anything that looks like investment advice, for example, and they can't actually handle the money flowing from investor to issuer. They can only facilitate transactions, by listing them on their websites.

The novelty of the crowdfunding portal makes it, from a regulatory point of view, a tricky beast, and would-be portals and other industry organizers created a trade group, Crowdfund Intermediary Regulatory Advocates, or CFIRA, to fight a determined but low-profile battle on some of the finer points. Can they take commissions? The SEC now says that they can. Can they choose, subjectively, which deals appear on their platforms? No--at least, not according to the proposed rules; instead, they can set criteria for the transactions they will list but then must allow every company that meets those standards to sign up. As a result, portals are likely to specialize, either by geography or sector or both.

Paul believes the financiers will have an advantage over the people coming from Web-based businesses and social media. "There are very few things that are more highly regulated than financial services," he notes. "It's totally anathema to the ethos of the tech industry, where anything goes."

As the portal operators have been waiting for the crowdfunding rules, they have also turned their attention to another part of the JOBS Act. Private placements for startups have long gone without registration, so long as relatively small groups of sophisticated (or "accredited") investors were involved and no general solicitation advertised. But under Title II of the JOBS Act, companies and their intermediaries can now broadly advertise a private placement, provided they verify that their ultimate investors are accredited.

Originally, the crowdfunders saw a private placement as a potential complement to Title III crowdfunding; they could do side-by-side raises with the crowd and with the select. But as their expensive technology sat idle, they began to look at--and, confusingly, describe--these freely advertised private placements as crowdfunding, even though the crowd of accredited investors is comparatively very small. Some portals, including SeedInvest, began taking private-placement listings for general solicitation. "Given the fact that the rulemaking process has been delayed substantially," says Feit, "we, like any other kind of startup, were forced to pivot and focus on accredited investors only."

By early March, SeedInvest had completed 20 private placements, helping those companies raise $14 million. In one instance, a well-known venture capitalist referred his 300,000 Twitter followers to SeedInvest's offering for a moped-sharing service in San Francisco called Scoot. Online investors ended up contributing $280,000 to Scoot's $1.5 million campaign, which lasted just five weeks. "It not only shows you how powerful Title II is," Feit says, "but it shows you how powerful Title III will be once you open it up to all your customers."

At the same time, Feit and the others will have to compete with the existing crowdfunding platforms that take donations and offer rewards instead of selling equity. Kickstarter has said that it will not enter the equities market, but Indiegogo and RocketHub, the other major incumbent platforms, seem likely to become portals. Each has at least four years' experience with proven technology and is itself well-funded--Indiegogo has raised $57 million; RocketHub doesn't disclose how much it has raised. Alon Hillel-Tuch, RocketHub's co-founder and CFO, rarely misses an opportunity to mention the overwhelming advantage he has over the new entrants. "Two years from now," he told me in March, "the other people you've been talking to aren't going to be around."

Then: Are You Cool Enough For The Crowd?

Somewhat surprisingly, many in the crowdfunding industry doubt whether tech businesses, especially those with business-to-business software such as Diggen, are suitable for crowdfunding. There's a broad sense in the industry that a successful campaign supports a discrete project, if not a product, something with goals and milestones, something that people can get their head around. Brian Meece, a co-founder of RocketHub, calls this your "why." But more than merely understand it, people have to connect with it, maybe intellectually, more likely emotionally.

Sometimes--maybe always, to some degree--the connection that funders make isn't with what you do, it's with you. At a crowdfunding conference in Boulder, Colorado, two summers ago, Meece told a story about his own effort to crowdfund his band. "I thought I knew my why, and it's because my music rocks," he said with conviction. But he quickly discovered that people contributed because they could see how much it meant to him, how it made him happy. And they could relate to that.

Not only, then, does your project have to be cool, but you have to be cool, too--people aren't really going to care if you're happy unless they like you. And the contributions from friends vouch for your credibility among strangers. As Meece puts it: "Crowdfunding is like an online event. It's like a party. Who wants to go to a party that nobody else is going to? I don't." That gut sense that popularity creates popularity seems to be true, at least for the incumbent crowdsourcers. According to Slava Rubin, Indiegogo's CEO, campaigns that raise a quarter of their funds in the first week, from their fans and followers, are five times more likely to hit their target than those that don't.

Guess What? It's Not As Cheap As You Think

Even if you're part of the cool crowd, crowdfunding success will come at a price. For all the talk about crowdfunding's potential to disrupt traditional finance, it's hardly shaping up to be a cheaper source of capital. The biggest upfront expense will be, of course, the transaction itself. Daryl Bryant, who co-chairs the trade group CFIRA's portal committee, figures that most platforms will charge 7 percent to 12 percent. (His own portal, StartupValley, will be "in the lower end of that," he says.) FundAmerica, a broker-dealer based in Atlanta, will charge 8 percent. "There's a high cost in running these portals, and not everyone's going to succeed," says Bryant. "And not everyone's going to be a million-dollar offer, so you're going to get a lot of $250,000, $500,000 deals, and you need to be compensated for your time."

"Crowdfunding is like a party. Who wants to go to a party that nobody else is going to? I don't."

On top of that, payment-processing services typically charge donation-based crowdfunding incumbents 3 percent to 5 percent to transfer funds from donor to recipient. If that rate holds for securities crowdfunding, then a company's crowdfunded proceeds could be shaved by as much as 16 percent or 17 percent right off the bat--all for the privilege of parting with a piece of your company. (Some portals say they plan to use electronic payments from bank accounts, which would be much cheaper.)

Douglas Ellenoff, a securities lawyer who has been advising the industry during the SEC rulemaking, insists that some platforms will find ways to drive down costs through standardization. "There will be others who are going to simplify what can be done on their site, so that forms can be created, and they won't allow variations," he says. RocketHub, for example, will require all its issuers to be C corporations and sell the same class of stock, says Hillel-Tuch--and keep its commission down at about 4 percent or 5 percent.

If those were the only costs associated with crowdfunding, it still would be an expensive proposition. But they're not. A significant outlay, for all but the smallest campaigns, will go to the CPAs who must sign off on the financial statements. Companies that raise from $100,000 to $500,000 must have an accountant review those statements. The SEC estimates this will typically cost $14,350, but it would easily be more for a big company in an expensive city. A company raising $500,000 or more (up to the $1 million limit) must submit its financial statements to a much more intensive audit, which the SEC estimates will cost $28,700. But again, that's just an average. Imagine a large company in New York City: It could easily find itself paying $50,000, or at least 5 percent of what it hopes to raise. "I just don't see people raising more than half-a-million bucks through Title III as long as that audit requirement is there," says Scott Purcell, FundAmerica's chief executive.

For issuers, all this paperwork represents risk: If the campaign doesn't meet its goal, then, per the JOBS Act, the company gets no money at all, and the considerable sum spent on disclosure has been lost. On the other hand, if the campaign succeeds, then the company must continue to make at least the same disclosures every year for as long as the securities remain outstanding. The financial statement reviews or audits will cost nearly as much as the initial versions, says John J. Hughes, a CPA at the New York City firm Marcum. Imagine now that New York City business, spending $50,000 year after year.

Ellenoff believes that all these costs will eventually come down: If technological solutions don't present themselves, then issuers will simply gravitate to intrastate crowdfunding markets, where disclosure rules are more forgiving. (In March, Maine became the fourth state to legalize local securities crowdfunding.) When that happens, "there's going to be a movement afoot at the federal level to make it work better," Ellenoff says.

Next Problem: Will There Be Enough Trust?

The industry argues that the crowd's capacity to sniff out fraud makes audited financials unnecessary, but it will take several years of experience to bear that out. Until then, it may turn out that when it comes to small business, it's simply not possible to strike the balance between access to capital and investor protection. Richard Swart, who directs research into innovative entrepreneurial finance at the University of California, Berkeley, does not forecast sharp growth for crowdfunding, at least for the first few years, partly due to regulatory costs. "I think it sputters along relatively slowly, and I think you see a lot of existing small local businesses funded by their existing customer base," he says.

The JOBS Act's opponents have raised the prospect of widespread fraud, but truthfully, fraud will probably not be a major problem in crowdfunding. The Senate's investor-protection regulations--or the wisdom of the crowd, depending on your point of view--see to that. The problem for the crowdfunding industry, and by extension issuers, is that the investor protections that do exist will still not be enough to protect investors--not from con artists, but from themselves.

The crowdfunding industry, to be sure, doesn't see this as a problem. In the early days after the 2012 law passed, at least, many were outright cavalier about the fate of the crowd's investment. One day in July 2012, Ruth Hedges, a founder of CFIRA who sells business-planning and due diligence reporting software at Crowdfundingroadmap.com, gleefully compared the closing hours of a future equity offer to the frenzy of a Mega Millions lotto drawing. We were standing in the hall of a Washington, D.C., law firm, and I wondered if it wasn't impolitic to liken an offering to gambling. "But it is gambling!" she exclaimed, incredulous that I would tiptoe around it. The others around her nodded. "And we say so right in our documentation!" she adds.

Hedges is right, of course. There's a reason small businesses find it so difficult to raise capital from traditional sources: As an asset class, they're a bad bet. The Small Business Administration reports that only about half of all new businesses typically make it to the fifth year. Among so-called growth companies, the failure rate is even higher, according to a 2012 Harvard Business School study: About three-quarters of startups with venture backing fail. Even when crowdfunded companies don't fail, it may be difficult to find a buyer for those shares.

There is bound to be, then, a substantial cohort of disappointed, even angry, investors after the first round of crowdfunding. And the question that the crowdfunding industry doesn't seem to have asked itself--or, at least, discussed openly--is what impact that might have on the future market for these securities. If the first wave of shareholders feel they have been burned, where will the second wave come from?

Running From The Crowd

These days, supporters of the crowdfunding industry don't draw too many comparisons to gambling. Instead, they emphasize the benefits of drawing on large groups of knowledgeable people. After all, the two top reasons small businesses fail in the first five years are a lack of access to capital and a lack of access to expertise. At least in theory, argues D.J. Paul, crowdfunding can mitigate both of those. "At least some of the people in the crowd," he says, "will have some expertise in your vertical--that's why they're investing--and they will offer that advice to you."

But even when investors win, they might lose. Early on, Swart predicted that smart issuers will use a reverse convertible debt note, that is, stock that becomes a bond, an idea that so baffled the audience in Boulder that he had to repeat it twice. "I think that no one in their right mind will want a thousand or 2,000 equity investors in their company," he explained. "You're going to want to figure out how to get rid of them."

Even before the JOBS Act became law, the industry's pioneers were consumed with the riddle of how you make a crowdfunded company attractive to venture capital and private equity--there was a presumption, advanced by some venture capitalists, that no subsequent funder would want to deal with a thousand other shareholders. Hence, reverse convertible debt. The latest idea making the rounds in crowdfunding circles is a variant. "We've already seen a couple of deals in Europe where it's been pre-negotiated that, if there's a subsequent funding round, you're going to get bought out at a set price," says Swart.

In other words, for the crowd it's unlimited downside, limited upside. But Swart takes a different view. "It depends on what you negotiate that price point at," he says. "If you say, 'If in five years we're acquired, we'll guarantee you x price that's twice your original investment,' that's not a bad deal."

The crowd might see it that way. Or they might watch as those subsequent funders make, say, five times their investment, and see it as the system being rigged, whichever system you're talking about.

Back in San Diego, the notion of an angry crowd was probably the furthest thing from Fabrice Gould's mind as he prepared to leave the convention center. He had thought that perhaps his network of Southern California investors might seed a successful crowd campaign. But given the costs and complexities of crowdfunding, and some of the doubt aimed at tech companies like his, Gould couldn't shake a persistent skepticism. After all he saw, a traditional private placement still looked like a better bet. "Your crowd gives you the dumb money," he explained. "I'd prefer the smart money, because you're getting a finite number of investors. They know the industry, they have the contacts, the network, and they can mentor you, advise you, and grow your business as well."